Revised Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)
1A.1 If an equity or debt is an item of trading stock of the affected entity immediately before an alteration time, and its cost exceeds its market value at that time (the excess), its cost for Division 70 purposes and any deductions for outlays incurred to acquire the trading stock are reduced by an amount not exceeding the excess [Schedule 1, item 18, subsection 165-115ZA(5)] . The purpose of the restatement is to prevent inter-entity loss duplication where the inter-entity interest is trading stock.
1A.2 The reductions apply only for the purposes of calculating deductions under section 8-1 or deductible or assessable amounts for the purposes of section 70-35 in respect of income years ending after the later of the commencement time and the time 12 months before the relevant alteration time. [Schedule 1, item 18, subsection 165-115ZA(6)]
1A.3 If a company has elected something other than cost as the closing value for an item to which a restatement of cost applies in the period referred to above, the company may re-elect cost [Schedule 1, item 18, subsection 165-115ZA(7)] . This ensures that the company does not have to return an inappropriate amount of assessable income, for example, where the company has previously elected market selling value as its closing value.
1A.4 The reason for the special treatment of trading stock is the way that deductions are obtained on items of trading stock under the ITAA 1997 .
1A.5 Broadly, an entity can deduct the outlay to purchase an item of trading stock under section 8-1. If the item falls in value and is sold for less than cost before the end of the year of income, the deduction for the purchase and the assessable income returned effectively allows a 'net deduction' for the 'loss'.
1A.6 If, however, the item is on hand at the end of the year of income, the entity must value it (give it a closing value) for the trading stock provisions. Under those provisions, if the total closing values of items on hand at the end of the income year exceeds the total value of items on hand at the beginning of the year (items bought during the year have a 'nil' opening value), the excess is assessable. If the total value of items at the beginning exceeds the total value of items at the end, the excess can be deducted.
1A.7 Thus, if an entity had one item only of trading stock purchased during the year, and elected to use cost as a closing value, the deduction for the item's purchase price would be offset by the inclusion of assessable income equal to its cost. No 'loss' is claimed up to this point. However, if its market selling value is less than cost, and the entity elects market selling value at the end of the year of income, the entity will effectively recognise the difference (the 'loss') in that year of income.
1A.8 Subdivision 165-CD seeks to disallow recognition of this 'loss' to the extent that it duplicates the underlying losses of the loss company that has had an alteration time. By reducing deductions for the purposes of section 8-1 and by reducing the cost of the trading stock item under Division 70 at all times and in all respects (subject to a further reduction at a later time under this provision), the entity is effectively prevented from 'deducting' the loss.
1A.9 The reductions are taken to occur only for the purposes of determining deductions and differences between total closing stock and opening stock values for years of income ending after 12 months before the alteration time. That is, the reduction applies only for the purposes of determining deductions, and an item's opening or closing value in a year of income that ends within 12 months before the alteration time, or in a year of income after the alteration time.
1A.10 The effect of this is that, if an item of trading stock (consisting of an equity or debt) was valued at cost for a year of income ending less than 12 months before the alteration time, that value is reduced in calculating the item's opening or closing value for that year. This prevents the entity from deducting the duplicated loss. However, if the trading stock (the equity or debt) was valued at its market selling value in an earlier year, the entity has already deducted the duplicated loss or a part of it before the relevant 12 month period and Subdivision 165-CD will not disturb that deduction. This is consistent with the treatment given to non-trading stock assets under this Subdivision.
1A.11 Once an item's cost has been reduced, the reduction continues to apply where the entity chooses 'cost' as its closing value at the end of any later year of income. An entity is also allowed to re-elect cost as a closing value during the period for which the reduction to cost occurs.
Example 1A.1 A 100% equity interest in a loss company that is an item of trading stock is acquired for $10,000 when the overall loss of the loss company is $20,000.The loss company makes a further loss of $6,000 during the next year. An alteration time then occurs, and at the time immediately before the alteration, the stock has a market selling value of $4,000 which fully reflects the further loss.The duplicate (net) deduction of $4,000 could be realised by sale or by adopting a market selling value as a closing value. That is, if the stock's opening value was cost ($10,000) and its closing value for Division 70 purposes were market selling value ($4,000), a (net) deduction of $6,000 ($10,000 - $4,000) would arise which multiplies the loss already recognised in the loss company in respect of this amount.What the measure does is reduce the cost of the item for Division 70 (and its purchase deduction) to $4,000. This effectively reverses a deduction of $6,000 for a duplicate loss.
Example 1A.2 X Co acquired an interest in a loss company being an item of trading stock for $10 million. At the first alteration time in the following income year, it had a market value of $6 million. The decrease in market value reflected the overall loss of the loss company. X Co had elected market selling value of $8 million as its last closing value. At the first alteration time, the company's purchase deduction would be reduced to $6 million under section 8-1. However, unless X Co were able to re-elect its closing value, it would record a (net) income of $2 million for that year [$6 million deduction for purchase and $8 million (difference between closing and opening value (taken to be nil))]. This is inappropriate. X Co is therefore allowed to re-elect cost which ensures that no 'net' income is returned for that year.
1A.12 The Subdivision also deals with a case where a relevant debt or equity interest was not an item of trading stock immediately before an alteration time but later becomes one and, had it been trading stock at that time (or an earlier alteration time), its cost would have exceeded its market value. [Schedule 1, item 18, subsection 165-115ZA(9)]
1A.13 Under Division 70, the entity has the option of choosing to bring the asset into the trading stock provisions at either cost or market value. Even though the Subdivision has prevented the multiplication when the asset was not an item of trading stock, the ordinary Division 70 rules would allow the item to be recorded at actual cost, which reflects the multiplied loss.
1A.14 This multiplied amount could then inappropriately be obtained as an effective deduction through the operation of Division 70. It is therefore provided that, for the purposes of Division 70 only, the cost of such an asset is taken to be its market value immediately before the alteration time, or if cost has exceeded market value at more than one time, the smallest of its market values at these times. [Schedule 1, item 18, subsection 165-115 ZA(9)]
1A.15 This Subdivision prevents the multiplication of a company's losses on inter-entity interests which themselves generate 'losses'. The Subdivision does not address reduced gains on the disposal of such interests even though the company's loss may have impacted on the value of the interests and resulted in a smaller gain on disposal than would otherwise have been the case.
1A.16 In the case of trading stock, it is possible that upon realisation the disposal proceeds may exceed what was, or would have been, the market value of the stock, on which a reduction was based, immediately before an alteration time. That is, a net gain may actually be realised on the realisation of the trading stock relative to the position at the time immediately before the alteration on which the anti-multiplication reduction was based.
1A.17 To ensure that trading stock is not treated differently under this measure from non-trading stock assets, where the proceeds of disposal of the equity or debt exceeds its market value immediately before an alteration time, the proceeds are reduced to the extent of a reduction, or reductions, previously made to its cost under subsection 165-115ZA(5).
1A.18 The reduction to the proceeds is not to exceed the excess of the proceeds of disposal of the equity or debt over its market value immediately before the alteration time, or the greatest excess (if more than one). [Schedule 1, item 18, subsection 165-115ZA(10)]
1A.19 This has the effect of ensuring that assessable income is reduced to the extent that the earlier anti-multiplication reduction is found, on ultimate disposal of the trading stock, to have been excessive.
Example 1A.3 A relevant debt or equity interest that is trading stock immediately before the alteration time has an opening value (based on cost) of $20,000 and a market value of $10,000. The company in which the interest is held has an overall loss of $10,000 which is fully reflected in the market value of the trading stock and duplicates it.The effect of the reduction provisions is that the cost of the trading stock is reduced to $10,000 and its deduction on purchase is reduced to the extent it reflects and duplicates that loss i.e. by $10,000.Sometime later, the trading stock is sold for $20,000. But for the reduction to its deduction, the holder of the trading stock would normally be assessed on $20,000 and, having been allowed a deduction for $20,000 under the trading stock provisions, the net effect would be a nil amount of 'income' or 'gain'.However, because of the reduction, a net amount of $10,000 income would be recognised. This is inappropriate because the trading stock cost $20,000 and was sold for $20,000.A compensating adjustment is required because $10,000 more than the unrealised market value of the stock immediately before the alteration time has ultimately been realised. The sale proceeds are therefore reduced to $10,000.If the stock were sold for $45,000 instead of $20,000, the sale proceeds would also be reduced by $10,000 to $35,000. In net terms, the holder would be appropriately 'assessed' on $25,000.